Written by Jonathan Wilson, Equities Analyst, StocksInValue. First published on 27 February 2015.
When Medibank Private (MPL) listed in November we thought the retail price of $2.00 was excessive. Now trading around $2.50, MPL is priced for (rather than to) perfection.   The stock no doubt has attractive features, for example,  leading market share of ~30% in an industry growing faster than the economy due to the ageing population.
Health insurance remains fragmented however and private health cover is becoming increasingly unaffordable. 1H15 results were subdued and MPL expects further customer churn and product downgrades. MPL aims to increase margins but industry dynamics are unsupportive. We think the stock is worth around $1.60 and we struggle to justify a valuation above $1.85.

Figure 1. MPL adopted valuation metrics and future value
Source: StocksInValue
Our adopted Normalised Return on Equity (NROE) of 25% reflects a long term view of profitability and is in line with consensus expectations. We think MPL can sustainably reinvest eight percentage points of this 25% NROE.
Our required return, which represents a percentage measure of the risks to the realisation of our adopted NROE, is 11.5%, which represents a lower risk relative to other companies. As the largest private health insurer, with ~30% market share, MPL’s scale grants some opportunity to drive cost advantages over competition and negotiate lower healthcare costs with private hospitals to offset regulatory risks to earnings. MPL lacks pricing power and its prices are directly controlled by politicians In recent years premium increases have exceeded claims increases, with regulated increases generally passed on to members. Although this has supported stable revenues and margins, if the trend continues insurance will increasingly become unaffordable for many people. MPL’s privatisation has reduced government’s incentive to allow premiums to increase faster than claims, as taxpayers no longer own equity in MPL. Further, government policy is to increase competition in private health insurance.
The resulting equity multiple in the valuation is 3 times. This means we think MPL is worth 3 times equity per share. MPL is worth $1.63 based on our assumptions. It is cheap below $1.40 and expensive above 1.90.
Despite reporting revenue and net income increases and reaffirming guidance for FY15 the result was subdued on operational metrics.
Medibank-branded policies, which represent 87% of principle policyholders, declined 1.5% on the prior corresponding period. This was offset by a 20% increase in cheaper AHM-branded policies, resulting in growth of overall principle policyholders of just 1%.
Underlying gross margin contracted to 13.4% from 13.7%, reflecting reduced policy affordability resulting in product downgrading.
Managing Director George Savvides said “The level of product downgrading and churn across the industry is a clear sign that affordability remains an important issue for customers. We are proactively addressing rising healthcare costs through our health cost leadership initiatives and a disciplined focus on finding efficiencies and reducing managing expenses. Delivering affordable and high quality healthcare for policyholders is our clear priority.”
Management expects health insurance industry headwinds to continue, resulting in further product downgrades and churn.
MPL is profitable but an expansion of profitability (NROE) to the level implied in the current share price (37% – see above) is unlikely given the regulated capital structure.
Management expense savings are a potential source of increasing profitability in the core health insurance business. MPL achieved this in 1H15, lowering its management expense ratio (MER) to 8.0% from 9.2%. On an absolute basis management expenses fell 9% to $235m. MER fell incrementally across the industry from 13.1% in 2000 to 8.8% in 2013, reflecting industry growth and operational leverage of insurers. Positively MPL’s MER is below peers, however to achieve the 37% NROE implied by the share price the MER would have to be ~2%, which is unachievable.
MPL’s long term growth is supported by rising health care expenditure, which is increasing faster than GDP: per capita healthcare costs have compounded at 6.2% pa over the last 10 years, whereas Australia’s long term GDP growth is ~3.5%. This trend is set to continue due to solid population growth and the aging population, as older people use more healthcare services. Most healthcare costs are met by governments – only 8% of national costs are covered by private insurers – so private health insurance will become increasingly important. Industry growth supports MPL’s annual growth at around 5%.
In summary:

  • Trading on an elevated multiple of 25 times FY15 EPS there is no margin for a disappointment. The $2.00 float was priced for perfection, as John Abernethy argued at the time.
  • Most key P&L drivers other than management expenses were a little weaker than the run-rate required to comfortably meet prospectus forecasts. Project and marketing costs were skewed to the 2H, inflating the 1H. Earnings upside is biased towards management expenses but this is a finite source where MPL has already done well. Investors really want to see faster revenue growth and a lower claims ratio but soft 1H15 revenue drivers are largely entrenched in the short term.
  • Industry conditions, particularly consumers’ propensity to trade down, are challenging, making it difficult to convert hard-won claims savings into higher margins. This lack of consistency means the stock does not deserve a premium rating.

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